2-28 Adjustable Rate Mortgage

How does a 2 28 Adjustable Mortgage Rate work?

2 Answers

The 2/28 mortgage is a class of home loan known as a 'hybrid" Adjustable Rate Mortgages (ARM). "Hybrid" means the loan combines features of both fixed and adjustable rate loans; in this case the interest rate is fixed for 2-years (or 3, 5, 7, 10 and longer) and then begins adjusting (either up or down believe it or not!) on either a monthly, semi-annual or annual basis.

Responding to historically low interest rates, a sharply appreciating real estate market and millions of new homes for sale, bankers adopted this type of loan to give more people the opportunity to become homeowners. As rates began to rise in 2004, the 5-, 7- & 10-year ARM is also a viable alternative for well-qualified borrowers to purchase or refinance without paying the premium for a fully fixed rate (especially given the constant rise/fall cycle of rates).

As with everything, there are pros and cons to the 2/28:

THE GOOD: Generally, 2/28 interest rates have starting (or "teaser", like your credit card) rates well below the market for fixed rate products (usually 15- and 30-year). This means a borrower who might not qualify (due to credit, income or other deviations from standard lender guidelines) for a higher, fixed rate loan can still get their purchase or refinance money. Investors (a.k.a. "speculators" and "flippers") also used this loan heavily in recent times as their intention was not to pay off the mortgage, but instead buy and refinance/sell within a short period. From the banker's point of view, since this borrower carried more risk coming in, compensation came from a higher fee structure and a note rate that eventually adjusts back to market par.

THE BAD: After the initial fixed period (usually 1-3 years), the interest rate becomes variable, which since 2004 usually means UP (few mention the fact that ARM rates/payments actually went DOWN during 2002-04)! Obviously, a sharp increase in rate/payment carries the potential of financial distress for the borrower who may be unable to sell or refinance their way into relief, so there's your double-edged sword.

THE UGLY: Many 2- & 3-fixed rate loans carry a Prepaid Interest clause (a.k.a. 'prepayment penalty') that stipulates the payment of interest (usually 6-month's worth) to the bank in the event the loan is paid off early (1- to 3-years usually). These clauses are generally stated clearly and plainly during loan origination, within the loan documents and verbally just before closing (they are not even legal in some states).

Naturally, this sounds like a 'mean' way to do business, but in most cases this 'commitment' period is what actually makes the loan, interest rate and payments affordable in the first place. The bank made a higher risk loan but still offered a below market rate; in return, we either pay them for the privilege over time (monthly payments) or pay it all at once (the "penalty"). In any event, prepayment period should NEVER, EVER extend past the Fixed Rate Period.

Lastly, ARM interest rates are NOT "controlled" by the bank. Interest rates are generally pegged to one of the publicly published mortgage market indexes such as the LIBOR, MTA and COFI. You can get an idea about how your ARM interest rate may change by looking these indexes up for yourself.

Remember: It's all about risk. When a bank lends $250,000, they are taking a big risk (with other people's money). The only insurance they have is your income, good payment history and ' in the worst case of all, the property they secured the loan to.

To understand how a 2/28 Adjustable Rate Mortgage (ARM) works, you must know what the loan is tied to with respect to the interest rate, margin, and caps. All ARMs have an index rate that they are tied to. The most common index rate tied to the 2/28 is the 6 month London Inter Bank Offered Rate (LIBOR). The loan will adjust every 6 months after the first adjustment. The loan also has a margin that the lender adds to the index rate which is tied to the loan. The margin is fixed throughout the life of the loan. The loan also has caps tied to the loan. The caps restrict the interest rate movement every adjustment period.

Let me give you an example of this loan. We have a 2/6 LIBOR ARM with a 2 Year Hard Prepayment Penalty (PPP) with an interest rate of 6.25% and a margin of 5.875% and caps of 6/3/6. The loan is fixed for two years at 6.25%. After the fixed period the loan will adjust based on the 6 month LIBOR. Currently the 6 month LIBOR is at 5.095%. If we add the margin and the index rate, we are looking at a fully index rate of 10.97%. Remember that there are caps that restrict rate movement. In this case the life cap of the loan is 12.25%. During the first adjustment period the loan can go up as high as 12.25% because the first adjustment cap is 6%. Every period after the loan will adjust +3% or -3% which affects the fully index rate. Since the loan has a 2 yr. PPP you cannot sell or refinance for the first years. If you do it will cost you 6 months of interest based on the original loan amount.

This is a very aggressive loan program. The margin makes this loan very unattractive because of potential payment shock. In fact, this loan has been the culprit of why many people are losing their homes today.